US ferrous scrap futures 101

Commodities, from iron ore to steel to scrap to soybeans to orange juice, are bought and sold either on an immediate-delivery basis (called the cash, or prompt, market), or as a contract for future delivery. Through all stages of the commodity price cycle, futures enable buyers and sellers to lock in prices, volumes, quality and delivery dates.

Futures, among the earliest risk-management tools, have been used for almost two centuries by farmers and processors of agricultural products to mitigate the huge volatility caused by weather, pests, consumer demand and transportation issues. Other commodities, such as fuels, also lend themselves to risk management through futures due to volatility that often is driven by geopolitical risk or supply disruption.

In contrast, ferrous metals--and steel in particular--have been slower to adopt futures because temporal effects, such as weather and political upheaval, are less of a factor, and huge global production volumes create a buffer against outages, so supply is not easily disrupted except on a highly localized basis.

The weight and volume of ore, steel and scrap products drive logistics to fewer, larger hauls, as well as to large inventories--another structural hedge against outages, but at the same time a financial risk due to inventory cost. In scrap, there also has been another factor working against the use of futures: an asymmetrical market with a relatively small number of large mills or trading companies buying from a relatively large number of smaller scrapyards and other sellers. In any market in which one side routinely sets terms, there is less need for that side to use outside risk-management tools.

Futures include two types of contacts: bilateral and exchange-traded. When most people think of futures, what comes to mind are exchange-traded contracts handled through a broker on a large, public, commercial exchange. But any contract negotiated directly between any two parties for a year or longer also is a future. As bilateral deals, futures contracts have long been a staple of the steel supply chain.

Exchange-traded futures contracts in the steel supply chain are more recent developments. Contracts for iron ore and, more recently, hot-rolled coil have become actively traded in volume only in the past few years. A scrap contract in Turkey has been traded for several years but it was not useful for North American buyers or sellers, and last September CME Group Inc. launched a U.S. scrap futures contract.

To be sure, exchange-traded futures contracts are just one risk-management tool, and the use of any such tools--or none at all--is up to a companys senior management. But it should be an informed decision that is not overly influenced by ingrained practice or hampered by lack of understanding.

All futures contracts set a standard size, value, tick size and price limit. Size is the number of units of the underlying commodity in the contract. Value is the size of the contract multiplied by the current price per unit of the commodity. Tick size is the minimum price change in a futures or options contract; a tick is the smallest amount that the price of a particular contract is allowed to fluctuate. Ticks are usually expressed either in dollars or in percentages and basis points; just as there are 100 pennies in a dollar, there are 100 basis points in each percentage point.

Some futures markets impose limits on daily price fluctuations. A price limit is the maximum amount the price of a contract can move in one day based on the previous days settlement price. These limits, set by the exchange, are intended to mitigate volatility. Meaningful trends and sentiments can carry on; the intent is to temper knee-jerk reactions, or overreactions. When a futures contract settles at its limit bid or offer, the exchange may decide to modify the limit to facilitate transactions on the next trading day, which could help futures prices return to a level reflective of the current market environment.

Buying or selling a contract means having an open position. Some open positions can be secured by a performance bond, an amount of money that must be deposited with a broker to open or maintain a position in a futures account. Buyers make bids, or what they would be willing to pay, and sellers make offers of what they would like to charge. Haggling ensues.

All futures contracts have an expiration date. Some contracts call for the physical delivery of the underlying commodity or financial instrument to an approved warehouse; others simply call for cash settlement. Every futures contract specifies the last day of trading before the expiration date. Players must be aware as the date approaches because liquidity, or activity in the buying and selling of that particular contract, tends to decline as traders begin to exit or roll their positions over to the next available contract month.

The CMEs U.S. Midwest No. 1 busheling ferrous scrap futures contract is traded under the symbol BUS. The standard size is 20 gross tons, the tick size is one penny, and there currently is no limit. Expiration is the 10th day of each month, or the next business day if the 10th falls on a weekend or holiday, and settlement is financial, not physical.

Recent contract prices have ranged from $404 per gross ton for April futures--settled on March 13--to between $385 and $406 per ton for the remainder of 2013, $392 per ton for 2014 and $390 per ton for the first few months of 2015. Contracts are listed 24 months out.

Market participants are either hedgers or speculators. Hedgers are usually those with a position in the physical market for the commodity--a yard or processor with scrap to sell or a mill in need of raw material. Hedgers also can be those with a tangential or related interest in the physical market, such as scrap haulers or customers of mills using scrap.

Speculators are just that: They are in the futures market to make money by playing the direction of the market. In times of extreme price movement, speculators are often criticized for distorting the market. That condemnation has been true in some instances, but in many cases speculators provide the bulk of market liquidity, which allows hedgers to enter and exit their positions efficiently. Arbitrage, a similar practice, profits on the difference in price for the same commodity or investment between different markets.

Market makers are trading companies that have contractually agreed to provide liquidity to the markets, continually providing both bids and offers, usually in return for lower trading fees. Market makers make money by capturing the spread between bids and offers.

Clearing is the other essential element to exchange-traded futures. Like a sports referee, it tries to ensure that everyone plays by the rules. Counter-party risk is a significant liability, especially in global trading. Clearinghouses confirm the creditworthiness of both sides in a deal and facilitate deal execution. The CME owns its own clearinghouse, which is responsible for settling accounts, regulating delivery, facilitating the option exercise process and reporting trade data.

At the end of each trading day, the exchange sets a settlement price based on the days closing price range for each contract. Each trading account is credited or debited based on that days profits or losses and checked to ensure that the trading account maintains the appropriate margin for all open positions. The practice of marking accounts to market helps ensure that each account maintains sufficient capital to meet margin requirements on a daily basis.

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